Last week, Twitter CEO Jack Dorsey announced that Square, the financial company he also runs, will be launching a new platform for creating decentralised finance projects using bitcoin. Amid the customary, constant online noise surrounding cryptocurrency – looking at you, Elon Musk – these days, you would be forgiven for not giving Dorsey’s move the time of the day. Still, Square’s project might end up being remembered as a watershed moment – the moment decentralised finance, or “DeFi”, finally entered the mainstream.
In recent years, DeFi has emerged as one of the most consequential developments reshaping the cryptocurrency world. Rather than bitcoin, its ascension has been tightly linked to Ethereum, the world’s second cryptocurrency, whose decentralised network – or blockchain – allows for the provision of services and the execution of more complex tasks than just sending and receiving payments.
Arguably, it all started just after the ICO bubble of 2017, when thousands of entrepreneurs and chancers raised billions by selling cryptocurrency tokens online as if they were stocks in – often non-existing – companies. After the crash, Ethereum started crawling with a host of services – DAPPs, or decentralised applications – offering a wide range of financial operations, from loans, to futures, to exchanges, to algorithmic trading.
The selling point, as usual when it comes to cryptocurrency projects, was disintermediation. Users of these services would be unshackling oneself from real-world financial intermediaries, but also from cryptocurrency-focused institutions that had evolved into gatekeepers – from corporate cryptocurrency exchanges like Bitfinex and Coinbase to Tether, the company behind the stablecoin USDT (a digital asset whose price is theoretically pegged to the dollar). Ethereum’s decentralised financial apps allowed users to trade without undergoing the identity checks, anti- money-laundering regulation and other limitations of centralised alternatives. Plus, it was much more fun.
“The advantages that DeFi has are multifold. Number one: it is in theory up 100 per cent of the time, right? So because Ethereum is always up, so is DeFi,” says Lex Sokolin, the co-head of decentralised protocols at blockchain software firm Consensys. “And then there is composability, the ability to layer.”
That means that, on the blockchain, different applications can be programmed to work in sequence, one after another, in a single transaction – their individual operations arrayed and stacked together like LEGO blocks. One can easily design a program that would automatically borrow cryptocurrency from a lending platform, dump it on a decentralised exchange in the hope of making its price plummet, buy it back and return it, possibly pocketing a short margin – in a matter of seconds. Investing strategies become puzzles, jigsaws of software commands to compose on the fly.
“You can build the portfolio and when you have the portfolio, you can build margin, and when you have margin, you can build interest, and when you have interest, you can build an aggregator of fixed income, and then tokens and so on, and so forth,” Sokolin says. “This accelerates everything, and makes it go really, really fast – I think 50 to 100 times faster than if it were not built on DeFi.”
That is exciting, but not complication-free. “People are building really interesting – but mostly experimental – tools. These are being built mostly by amateurs who do not understand how actual finance works,” says Emin Gün Sirer, an associate professor of computer science at Cornell University. “So some of these ‘LEGO building blocks’ are quite interesting and do things that Wall Street cannot do. But some of them end up interacting in unforeseen ways.”
One of the first and most infamous manifestations of this unpredictability is the “flash loan” incident that sent waves through cryptoland on St Valentine’s Day 2020. On that day an anonymous trader managed to get away with a profit of $350,000 in Ether from lending platform bZx, after deliberately pumping asset prices on the exchange bZx relied upon to get its pricing data. The best bit? The money used in the coup de main had been borrowed from a platform that allowed users to take cryptocurrency loans – for a very short period of time: hence ‘flash loan’ – without providing collateral. The trader had transformed no money into a lot of money. Cue a debate about whether the trader could be labelled “a hacker” or simply someone who had read the fine print, realised that bZx could be gamed and acted accordingly.
The following months – what with the chaos and panic around the global pandemic, coupled with several regulatory crackdowns on centralised cryptocurrency exchanges – only made DeFi protocols such as MakerDao, Uniswap and Compound more popular amid the crypterati and the budding investors. By late-2020, the hottest thing in DeFi had become something dubbed “yield farming’”, a mechanism to earn new cryptocurrency tokens just by depositing other tokens on decentralised lending markets. That lent itself to the usual crypto-adjacent zaniness: projects hyped to the moon and then immediately crashing; memes and food emojis that – well before the GameStop craze and Elon Musk’s romance with joke-turned-token Dogecoin – have been traded like precious assets; and of course the occasional scam.
ICOs were no more, but the scramble to grab the governance tokens du jour, and get a piece of this or that DeFi protocol, was deeply redolent of 2017 – even if research suggests that the people engaging in this new gold rush are more financially literate than the poor saps who lost their shirts in the ICO frenzy.
In December 2019 about $1 billion in cryptocurrencies was underpinning DeFi protocols. By August 2020, that figure was close to $5 billion in Ether and bitcoin; today, the value of locked Ether only has skyrocketed to over $55 billion. Where this leads is anybody’s guess. Karl Floersch, a researcher at the Ethereum Foundation, thinks there is risk that a “cascading failure” could simply put an end to it all. For instance, he says, one of the main assets underpinning the DeFi ecosystem is Dai – a stablecoin, issued by decentralised organisation MakerDAO, which is roughly pegged to the dollar via cryptocurrency collaterals.
“Let’s say that Maker DAO becomes massively under- collateralised, ” Floersch says. “And all of the systems that rely on it go down – and everything goes down all together. There are kind of crazier risks like regulation, massive internet censorship, but I don’t think that those are quite as poignant as just a simple market failure. These projects are new, experimental, crazy. The people who build them are, honestly, real risk-takers.”
Jamie Burke, the UK-based CEO of Outlier Ventures, believes that for all its buccaneering experimentation, DeFi will eventually mature and be co-opted back into mainstream finance. “I think of DeFi as a sandbox: I’ve got a concept. I can test, validate that concept. I can understand the economics of it in this permissionless sandbox that is DeFi. Once I have done that, I can then raise money, I can hire the lawyers,” he says. “Ultimately, if you want mainstream users, the reality is that the average person wants the insurance policy of a regulated product.” (Some decentralised finance protocols are indeed moving in that direction.)
“ICOs are a really good example: everybody is all for ICOs and low levels of regulatory burden as long as they’re making money. The minute that they’re losing money, guess what? They become claimants for class- action lawsuits. So the idea that DeFi is somehow going to create a parallel system is nonsense.”
For the time being, the most lasting consequence of the DeFi boom is that it took Ethereum by storm. Its blockchain is now more like an online Wall Street on LSD – and the rise of NFTs (often also traded on the platform) did not help dispel that impression. That frothiness is prompting the project’s developing team to grapple with questions of scalability and speed – questions that have always been on the cards, but have now acquired a new urgency given the amount of transactions and money flowing across the platform. One solution might be the adoption of add-on “side-chains” on top of Ethereum’s main network. The Ethereum project, in addition, is in the midst of a staggered transition to a new architecture known as Ethereum 2.0 or Eth2. One big change will be the end of proof-of-work in favour of proof-of-stake – a process in which nodes verify transactions not by burning electricity through mining, but by down-paying a certain amount of Ether, which will be lost if they wave through an invalid transaction. The restructuring, which includes other major changes alongside proof-of-stake, aims at eventually bringing Ethereum’s capacity to 100,000 transactions per second – up from the current 15.
Whether Ethereum will retain its crown as the go-to DeFi ecosystem, or whether that will change – partly, one could imagine, because of projects like the one Dorsey announced – is the next big question in crypto. For sure, as cryptocurrency grows increasingly institutionalised, DeFi remains one of the last redoubts of crypto’s early decentralised yen. And that, paradoxically, is still worrying the big players. A few months ahead of its $86bn IPO, in June 2021, cryptocurrency exchange Coinbase groused in a SEC filing, “we do face significant competition from parties ranging from large, established financial incumbents to smaller, early stage financial technology providers and companies native to the cryptoeconomy, such as decentralised exchanges.”
This is an extract from Cryptocurrency: How Digital Money Could Transform Finance by Gian Volpicelli. Find out more and order your copy of the book.